BlackRock On Detroit Bankruptcy: ‘Idiosyncratic’

By Michael Aneiro

There’s that word again: idiosyncratic. BlackRock‘s Peter Hayes and James Schwartz become the latest muni strategists using that word to describe Detroit’s bankruptcy filing and distinguish the city and its peculiar woes from other muni-market issuers:

Detroit’s Chapter 9 filing on July 18 came slightly sooner than expected, but in no way was a surprise to the market…. Detroit remains an idiosyncratic situation. The city’s problems, while long known to the municipal market, have had little bearing on it—a scenario we expect will continue, even in the wake of the bankruptcy filing…. While some indirect action such as outflows or price weakness could ensue in the near-term as the market digests the news… we do not anticipate a widespread systemic effect….

We anticipate the impact of the event will be much smaller than its size might indicate. Overall, Detroit is first and foremost a Michigan issue. The broader municipal bond market has little to gain or lose in the near-term as the Motor City travels its difficult path ahead.

BlackRock says Chapter 9 bankruptcy isn’t well understood in part because it’s so rare, calling it “a costly last resort that eliminates capital market access for issuers and greatly increases future borrowing costs, if and when market access is restored.” BlackRock cites Moody’s data showing a muni default rate of 0.03% over the past five years, a period that included a severe recession.

Like other mun-market observers, BlackRock says the biggest likely impact of Detroit’s case is the potential to set court precedents for muni bondholders, because the status of general obligation bonds – which heretofore were deemed by municipalities to be of higher priority than other obligations like pension benefits – is being challenged under Detroit’s restructuring plan. From BlackRock:

Our view is that the emergency manager started the negotiations from a very stark place. His plan suggests all “unsecured creditors” share in a $2 billion limited recourse note in settlement of claims totaling more than five times that amount. This, in our view, was ostensibly an attempt to fulfill the Chapter 9 requirement to negotiate with creditors in “good faith,” but a clear sign that bankruptcy was the intended endgame.

In past instances where cities of like size have come under stress, states have interceded with public safety and social programs to provide support and right the wrongs. Michigan has previously dealt with smaller instances of municipal distress, and in those prior examples, state interventions have never resulted in non-payment of GO debt service. Like other states before it, Michigan has the option and authority to intervene to protect the creditworthiness of the state and its municipalities, and to ensure fair treatment of all interested parties. Inaction could cost the state and its municipalities much more in the long-term than Detroit saves today.

According to Standard & Poor’s Capital IQ, of the 10 largest multistate municipal exchange-traded funds, only two have more than 3.5% exposure to Michigan bonds. The PowerShares VRDO Tax-Free Weekly Portfolio (PVI), with a 5.5% Michigan exposure, is down 2 cents to $24.98 early Monday, and the PowerShares Insured National Municipal Bond Portfolio (PZA), with a 4% weighting, is down 17 cents to $23.10.